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Goldilocks at Chifley Square

The current level of the cash rate is assessed as being just right for the time being, but things could change. The Board also picks a happy medium as the future model for implementing policy.

The minutes of the late-March meeting of the RBA Board (the last in the Martin Place building) recorded that the data had turned out broadly as expected, and that this supported keeping the cash rate on hold. Unlike the February minutes, there was no mention of multiple policy options. While the Board endorsed the language of not ruling anything in or out, it seems that policy actions other than keeping rates unchanged were not on the table at this meeting. The current level of the cash rate is assessed as being just right, at least for the time being. 

The minutes noted that the staff assessed that demand still exceeded supply, but the gap was diminishing quickly. A slowing in labour demand was called out, and growth in labour costs was assessed to have peaked. The Board nonetheless remains concerned that domestic costs could continue to rise quickly. The recent turnaround in productivity was noted, as was the role of the pandemic and economic cycle in driving the recent slump. However, the Board is uncertain whether this turnaround will continue. The possibility of a faster snapback in productivity than expected was not mentioned.

The ongoing decline in inflation was highlighted, with the three-month-ended rate for the monthly indicator used as a timelier metric. Monthly inflation was expected to rebound in coming months as special factors such as electricity rebates unwind. The pace of decline in goods prices was also expected to slow, though the minutes did not elaborate on the reasoning for this view. The minutes highlighted the bumpiness of the decline in inflation in other countries and noted that something similar could happen in Australia. 

Policy was still assessed as restrictive, so at some point the policy rate will need to decline to prevent inflation from declining so far that it starts undershooting the target. But unlike its peers overseas, the Board is not ready to talk about this decision yet. The minutes again highlighted that interest rates had peaked at a lower level than in some peer economies, and that this reflected the Board’s intention to preserve the gains on employment made since the pandemic period. A related difference that the minutes did not highlight is the varying squeeze on household sectors across peer economies. Debt-servicing as a share of household income is well above average in Australia at present. By contrast, the financial stability section of the minutes noted that it is below historical averages in many peer economies – despite higher policy rates. 

The global outlook was seen as supporting risk sentiment. The chance of a significant downturn had fallen, while interest rates were still expected to decline later in the year. This combination is seen as boosting prices of risk assets and contributing to a more ‘risk on’ tone in markets. This has also been supportive of the Australian dollar exchange rate despite narrower interest differentials and a decline in key commodity prices. Improved risk sentiment also underpins Westpac Economics’ expectation of further upward pressure on the AUD/USD exchange rate later this year; the declines in commodity prices were largely expected and so already priced in.

We expect the RBA to reach the required level of assurance about the path of inflation later in the year, after the full suite of data for the first half of 2024 are released. We continue to expect the first rate cut to occur at the late-September Board meeting.

Ample considerations of a happy medium

The other main decision recorded in the minutes related to the operational arrangements for monetary policy. This decision was further elaborated in a speech this morning by Assistant Governor (Financial Markets) Chris Kent. 

The background to this decision is that the policy interest rate that the RBA focuses on is the interest rate that banks (and other deposit-taking institutions) charge each other to borrow unsecured overnight in the cash market. The asset that is being borrowed and repaid is exchange settlement funds – that is, banks’ deposits with the RBA, also known as reserves. These deposits are remunerated at a rate that is set below the policy target rate; currently, the spread is 10 basis points. 

Prior to the pandemic, the RBA ran a ‘scarce reserves’ regime. Its balance sheet was small, and the staff needed to forecast daily liquidity flows into and out of the system – for example from tax payments and government spending – to keep the amount of reserves at whatever level would keep the cash rate at target. When the pandemic hit, banks wanted more liquidity, so the RBA switched to a regime of excess reserves. This was also a by-product of the various asset purchase programs introduced during that period. The RBA’s balance sheet expanded, and the actual interest rate banks transacted at in the cash market drifted below the published cash rate target, while remaining above the remuneration rate on exchange settlement balances.

Other central banks, including the Federal Reserve, Bank of Canada and RBNZ, have decided to stick with the excess reserves model even as they wind down their asset purchase programs. Others, including the Bank of England and European Central Bank, have instead settled on a happy medium of ‘ample’, but not excess, reserves. A key distinction between this operating model and its alternatives is that it is managed with full-allotment repo at a pre-specified interest rate, which fixes the price (interest rate) and accepts whatever quantity of reserves is needed to achieve this. By contrast, in both the ‘scarce’ and ‘excess’ reserve regimes, it is up to the central bank to determine the quantity of reserves that it thinks will achieve the desired price. Still to be determined is the composition of assets the RBA will hold under repurchase agreements on the other side of its balance sheet. 

As both the speech and minutes emphasise, this is an operational decision with no implications for the stance of monetary policy. Relative to reverting to the pre-pandemic scarce-reserves regime, though, the RBA’s balance sheet will be larger, with implications for the average size of future earnings to be distributed to the government. It will also mean that the RBA continues to hold some fraction of the government bonds on issue. These will not be available to banks and other deposit takers to meet their prudential liquidity requirements (the Liquidity Coverage Ratio).

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